Thanking Peter Costello? American budget deficits and politics

The example of Barack Obama suggests that Kevin Rudd has much to thank Peter Costello for, the Howard government did not follow the example of the American right on fiscal policy and bequeath a huge deficit. The Democrats are struggling in the polls and may lose substantial grounds at the 2010 Congressional elections. They are divided about how to respond. One option is to nationalise the elections and rely heavily on the assumption that Barack Obama will still be reasonably popular, but as the media points out many Democrats represent districts that voted for John McCain. The difficult political fortunes of the Democrats are linked to the large budget deficit. With the economy showing only spluttering signs of recovery and unemployment not falling it is not surprising that concern about the deficit has an impact on voters and in response to this Obama has increasingly stressed his commitment to deficit reduction.  In Australia despite the strong economy voters prefer the Coalition strongly on ‘government debt’ and a substantial number of voters consider it an important issues. Concern about the American deficit is linked to a popular tradition of antistatism, even if voters tend to support specific government programs. The Democrats’ problems are twofold: 1) is that the original stimulus package was not large enough; 2) it is difficult to explain to voters that a large deficit now is a good thing to boost demand but that in the long run the government should aim to return to a budget surplus.

For progressives it is difficult because many of those who have suddenly discovered concern about the deficit are simply using it to oppose social expenditure whislt continuing to support unsustainable tax cuts or government hand-outs to business. However there are serious long term fiscal problems. Peter Orszag Director of the Office of Management and Budget summarizes these:

the deficit for last fiscal year was $1.4 trillion, or 10 percent of our economy. Next year’s deficit is expected to be about the same size, and current projections show $9 trillion in deficits over the next 10 years, averaging about 5 percent of GDP. Deficits of this size are serious – and ultimately unsustainable. So how did we get here?Of the $9 trillion in deficits projected over the coming decade, nearly $5 trillion comes as a result of failing to pay in the past for just two policies — the 2001 and 2003 tax cuts and the creation of a Medicare prescription drug benefit. The cost of the tax cuts will total about $4 trillion over the next decade, including the additional interest on the debt the federal government will have to pay since the tax cuts were deficit financed.  The Medicare prescription drug bill will add about another $700 billion to the deficit – bringing us to about $5 trillion total for the cost of just these two policies. In addition, roughly $3.5 trillion can be attributed to automatic economic stabilizers. As the economy enters recession, certain spending programs, such as unemployment insurance and food stamps, automatically increase and revenues tend to decline.  Although this helps to ameliorate the economic downturn by stimulating demand, it also leads to higher deficits. Finally, there is the Recovery Act which accounts for just 10 percent of the entire deficit over the next decade. All told, the entire $9 trillion deficit reflects the failure to pay for policies in the past and the cost of the worst economic downturn since the Great Depression and the steps we had to take to combat it. ..Over the long-term, deficits tend to have some combination of two effects. First, they can raise interest rates and decrease investment, as the federal government goes into the credit markets and competes with private investors for limited capital. Second, deficits can increase the amount that the United States borrows from abroad, as foreigners step in to finance our consumption.Either way—whether deficits increase interest rates or borrowing from abroad—the long-term effect is the same:  It generates a greater burden on you—our future workers. If interest rates rise and investment falls, that will make you less productive and reduce your incomes.  And, if we borrow more from abroad as a result of our deficits, that means that more of your future incomes will be mortgaged to pay back foreign creditors. From a quick look through the financial pages, you might think that what I’m saying is belied by the facts. Even as the deficit reached a record level, interest rates have been very low.  So far this year, for example, the nominal interest rate on the Treasury’s 10-year note has averaged roughly 3 percent.  If this holds out, this will be the lowest average annual interest rate on the 10-year note since the 1950s. And in just three years, the current account, or the amount that we borrow from abroad, has fallen in half as a share of the economy—dropping from 6 percent of GDP in 2006 to under 3 percent today. These seemingly conflicting trends—rising budget deficits but falling interest rates and borrowing from abroad—are a product of the extraordinary economic environment in which we currently find ourselves…Among households and non-financial businesses, total borrowing peaked at about 15 percent of GDP in 2006 and has since fallen to -3 percent of GDP as of the second quarter.  In other words, people and non-financial businesses went from borrowing an amount equivalent to about one-seventh of our economy to a situation in which currently, on net, they are paying back loans rather than taking new ones. Among U.S. financial-sector businesses, the shift has been even more substantial.  They went from borrowing an amount equivalent to about 10 percent of GDP as of 2006 to paying back about 15 percent of GDP in the second quarter, as the financial crisis has forced these companies to deleverage. Public sector borrowing has increased dramatically, but by a smaller amount than the decline in private sector borrowing. As a result, total domestic borrowing – public and private – has gone from roughly 30 percent of GDP as of 2006 to roughly zero now. That’s why interest rates remain low and the amount we borrow from abroad isn’t rising along with budget deficits – because the private sector’s demand for capital has collapsed and, for the time being, the Treasury is the one borrower left standing. That said, as the economy recovers, other borrowers are going to return to the market as consumer spending and business investment pick up again.  When that happens, the federal government’s borrowing to finance its deficits will be competing more directly with private-sector borrowers for capital. It is at this point that we are likely to observe a rise in interest rates, an increase in borrowing from abroad, or some combination thereof due to the deficits. And it is at that point that deficits will be putting the health of our economy in jeopardy rather than helping to mitigate the most severe economic downturn in more than 50 years – as they are now. While we are addressing our short-term economic crisis with deficit spending, as we must, we also are taking on the biggest threat to our long-term fiscal future: rising health care costs. Our fiscal future is so dominated by health care that if we can slow the rate of cost growth by just 15 basis points per year (that is, 0.15 percentage points per year), the savings on Medicare and Medicaid would equal the impact from eliminating Social Security’s entire 75-year shortfall.

The 2001 and 2003 tax cuts and the  Medicare prescription drug benefit are monuments to Republican fiscal policy. As Dick Cheney is reported to have said: “Reagan proved that deficits don’t matter. We won the midterm elections. Our due is another big tax cut.” The challenge for Obama after 2012 will be winning republican support for the taxation increases necessary to bridge the revenue gap. For Australia in the future it may be whether the Liberals follow the views of Julie Bishop and adopt the Republicans’  fiscal policy approach. Malclom Turnbull, as on most things, was confused on this question.

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